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Are you prepared for stock market winter?

This is not a panic post. I don’t know when the next market downturn would happen. I don’t care to know either. My investing is not based on predicting future events. As Howard Marks wrote once, “taking bold actions based on forecasts of things that are uncertain isn’t just misguided; it’s dangerous.”

What I consider a stock market winter is not when the market is down for a few months and recover quickly — perhaps within a year. It’s when stocks are down and stay down for an extended time — long enough to make media and regular Joe Blows turn sour on their future prospects. This state could last for several years. By the time stocks recover (which they always do, eventually), investing would no longer be a trending topic at parties.

I see too many people getting interested in stock investing for the first time. This is not surprising. When the market’s been on an upswing for this long, it produces many converts. Those who are invested in the stock market today, how prepared are you for an eventual downturn? Here are some questions you might want to ask yourself:

Do you know market history? How often it goes down?

I study past market returns to prepare myself for the future. Even though every market cycle is different from the previous one. Still, the market follows similar patterns every cycle. On average, the market goes down by 10% nearly every year — 20% every four years or so. 30% about once in a decade. In a previous blog post, I wrote about market declines and how often they happen: Beware, the markets go down often!

Since the US stock market hasn’t gone down by 20% in a long while (since 2009), chances are it will one day in future while I am still invested.

Do you realize you can’t time the market?

Don’t assume you will be able to get out of the market before it tanks. The market is not predictable. It often does the opposite of what most investors are expecting: Why does the market mock us?.

Yes it’s easy to set up stop-loss orders on all your positions. Say, the market drops by 10%, you sell all your positions to avoid further damage. But the market gives lot of head fakes too. It often goes down 10% to 20% only to recover quickly and resume its upward movement. In a previous blog post, I pointed out how from 2009 to 2012 — four years in a row — the US stock market dropped by double-digit percentage each year and still recovered quickly by the end of each year. Market timers would have bailed at the first drop and likely never made it back in time. Staying in cash nullifies the benefits of compounding — which is key to long-term wealth generation. I outlined my reasons for staying invested in stocks here: Why I stay invested in stocks?

Since 2008, the US stock market has only gone down a few times and whenever it did, it recovered quickly — within a few months. It’s easy to give up on stocks when facing multiple down years in a row. I was investing in a 401(K) during the 2000 — 2002 decline. I mostly kept on investing even though it didn’t feel good doing so at the time.

Are you overinvesting?

Putting money in the stock market that you will need in 3 to 5 years — in the hopes of making it big. You might be forced to pull money out of your stock investments for other needs (education, marriage, a new house, a new roof, etc.) while the market is down. That could do permanent damage to your portfolio.

Some late-bloomer try to make up for lost time by aggressively investing late in their earnings career. Are you one of them? I hope not — it usually doesn’t end well.

Do you have another source of income?

A steady job, a profitable business, retirement income, etc. Or are you counting on yearly gains from your stock investments to support your lifestyle?

My own experience is that when I have a steady source of income that is adequate for my near-term needs — and I am not counting on the stock market to keep me afloat — I can detach myself from the daily drama on the Wall Street and just wait out the down cycle. In other words, I can afford to be patient when I am not counting on my stock portfolio for income.

Do you have another hobby outside of stock watching? Or do you check market prices every day?

I use Quicken as my financial aggregator. It shows me a consolidated picture of my investments as they are spread over multiple brokerages and account types. Back in 2010, I remember feeling depressed every time I’d update Quicken and seeing more than 2/3rd of my positions in red. Today, when I update my Quicken portfolio, I get a dopamine hit. Nearly all my stock positions are in green (except a handful of oil-gas industry stocks).

Yet I don’t want to obsess over how well I am doing today — lest I become overenthusiastic. I want to stay even keel. Various studies have shown how investors tend to do excessive exuberant buying when the market is doing well and as a result pay the price when stocks stop doing so well.

Have you been through a bear market? Did you stay invested? What was it like?

I have been through two bear markets in my investing career. In both cases, they were totally unexpected to me. I never saw them coming. The first one was in 2000. I was young and inexperienced. It was all doom and gloom. The media was projecting it. Fellow investors were, too. I did sell some positions at steep losses; others I sold for tax loss harvesting but I did stay invested in my retirement account.

The second time was in 2008. The drop was steeper and faster that time. It didn’t feel good at all. But I stayed invested — knowing that the market will eventually come back and I have time on my side. I didn’t need to take any money out.

If you have never been in a bear market, you likely won’t really know until you experience it first-hand.

Do you understand how media behaves in a bear market?

Read up news archives from 2008 to 2012. Causes and panics will be different but panicking and fear mongering will be the same.

When the market stays down for an extended period, media inevitably projects pessimistic future for investors. We saw this in the 2009 – 2012 period. I previously wrote about financial advisors who thought that stocks have no place in retirement savings. Or a financial journalist announcing that “stocks are dangerous things to own” — just when they were about to go on an eight-year bull run.

It pays to learn how media has behaved in the past bear markets. How it is always looking at the rear-view mirror when projecting future. Understanding what to expect from it in the next bear market helps me stay even keel and not take any drastic measures when it is panicking.

So, am I prepared for a stock market winter?

I believe so. Am I looking forward to it? No. It’s never a good feeling to see the market value of my portfolio go down by 30% or 40%. But this is the price of admission to this game. To see my portfolio prosper and compound in value, I know I must stay invested throughout. I keep enough cash for my near-term needs. I also have dry powder cash to take advantage of market downturns. And above all, I try not to anchor myself to the current value of my investments. Instead, I focus on those businesses’ staying powers throughout the economic cycle – and their future earnings potential. After all, did Warren Buffett, Jeff Bezos, or Howard Schultz sell stakes in their companies during the last two bear markets? They didn’t. Then why would I?